RiskTech Forum

Capco: Stress Testing Credit Risk Portfolios

Posted: 10 April 2013  |  Source: Capco

In this study we survey practices and supervisory expectations for stress testing (ST) in a credit risk framework for banking book exposures. We introduce and motivate ST; and discuss the function, supervisory requirements and expectations, credit risk parameters, interpretation results with respect to ST. This includes a typology of ST (uniform testing, risk factor sensitivities, scenario analysis; and historical, statistical and hypothetical scenarios), and procedures for conducting ST. We conclude with a simple and practical stress testing example using a ratings migration based approach.

Modern credit risk modeling [for example, Merton (1974)] increasingly relies on advanced mathematical, statistical, and numerical techniques to measure and manage risk in credit portfolios. This gives rise to model risk (OCC 2011-12), and the possibility of understating inherent dangers stemming from very rare yet plausible occurrences perhaps not in our reference datasets. In the wake of the financial crisis [Demirguc-Kunt et
al. (2010), Acharya et al. (2009)], international supervisors have recognized the importance of stress testing (ST), especially in the realm of credit risk, as can be seen in the revised Basel framework (BCBS 2005,
2006; BCBS 2009 a,b,c,d,e; BCBS 2010 a,b) and the Federal Reserve’s Comprehensive Capital Analysis and Review (CCAR) program. It can and has been argued that the art and science of stress testing has lagged in
the domain of credit versus other types of risk (for example, market), and our objective is to help fill this vacuum. We aim to present classifications and established techniques that will help practitioners formulate robust
credit risk stress tests.

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